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The year gotten off to a difficult start for mortgage real estate investment trusts with a compression in the yield curve as well as widening of agency mortgage-backed securities spreads. Credit Suisse analyst Douglas Harter and his team still see attractive opportunities within the sector given the 12.9% discount to book value and juicy dividend yields.

PennyMac Mortgage Investment Trust (PMT), Two Harbors Investment Corp. (TWO), and New Residential Investment (NRZ) remain among their top picks.

But everything isn’t rosy. In the face of this challenging new investment environment, Harter, et al have taken a hammer to a trio of mortgage REITS, downgrading Armour Residential REIT (ARR), CYS Investments (CYS) and NY Mortgage Trust (NYMT) to underperform.

The downgrade took a bite out of stock prices. Armour, previously rated outperform, fell 5.4% in recent trading, while CYS and NY Mortgage Trust, both previously rated at neutral, fell 2.7% and 1.8% respectively.

Why the downgrades? Here’s how Harter and friends explained it in their note, published earlier today:

ARR – Downgrade to Underperform (from Outperform): The combination of a negative duration and relatively long dated hedges lead to book value underperformance in a flat curve environment. This combined with a below average historical risk-adjusted return profile lead us to a lower valuation.

CYS – Downgrade to Underperform (from Neutral): With above average economic return volatility we expect CYS to continue to have one of the lower price to book multiples among the Agency-only REITs leading us to believe the total return will underperform peers.

NYMT – Downgrade to Underperform (from Neutral): The continuation of a tight credit spread and low yield environment will make it challenging for NYMT to meaningfully expand core EPS in order to cover the dividend without relying on gains. This coupled with the highest price to book in our residential mREIT coverage cause us to see relative underperformance.

With dividend yields of 11.3% and 12% respectively, Annaly Capital Management (NLY) and American Capital Agency (AGNC) would seem like a dream for investors hungry for income.

After all, the yield on the 10-year U.S. Treasury note has fallen below 1.7% today to hit a 20-month low.

But in a note published today, Nomura analyst Brock Vandervliet initiated coverage on eight mortgage real estate investment trusts (REITs), with neutral ratings on all but two, citing a “transition” underway in the key growth and earnings drivers for mortgage REITs. In short, the industry faces the threat of higher interest rates driving up funding costs and a yield curve that continues to flatten, squeezing net interest spreads.

American Capital was initiated at a neutral with a price target of $21. Vandervliet writes:

AGNC faces similar headwinds as its peers, including the threat of higher interest rates driving up funding costs and a yield curve that continues to flatten, squeezing net interest spreads. Despite these factors, AGNC has delivered five years of consistently higher economic returns than peers. The company also has a strong management team with experience at Freddie Mac, and has opportunistically capitalized on “dollar roll,” an off-balance sheet financing structure. Our $21 target price for American Capital Agency Corp. (AGNC) is derived based on applying a 0.91x multiple to our 4Q16 book value per share of $23. F15E EPS estimate at $2.92 vs Consensus at $2.91.

At $21.49, the share fell 0.13% in recent trading.

Annaly Capital was initiated at neutral with a $10 price target. Vandervliet writes:

Dancing Until the Fed Hike. In addition to being the largest Agency REIT, a distinction of NLY is its greater willingness than others to adopt a directional interest rate posture. In both asset selection and in the structure and positioning of hedges, NLY is oriented for the Fed to leave rates unchanged. With lower leverage than the sector and no dollar roll earnings to add further complexity, we believe NLY can prudently assume this incrementally higher risk. However, we believe investors should be aware of this distinction in approach. Our $10 target price for Annaly Capital Management Inc. (NLY) is derived by applying an 0.89x multiple to our 4Q16 book value per share estimate of $11. F15E EPS estimate at $1.13 vs Consensus at $1.22.

For many investors it’s an almost knee-jerk expectation to see mortgage REITs as good safe haven plays when rates move lower.

Keefe Bruyette & Woods isn’t jumping on that band wagon. In a note published today entitled, ”mREITS: Safe Haven or Sinking Ships,” analysts Michael Widner and Eric Hagen suggest caution, warning that investors should be wary of both dividend and book value risk.

Granted, the sector has outperformed both the broader market and the financial industry so far this year. But the pair argue that the move was fueled primarily by valuation multiple expansion and “book values are down 5% on average from third quarter 3Q levels” by their estimates. Also, there’s worries about a prepay wave, a flatter yield curve, and Fed rate hikes weighing heavily on dividends and further pressuring valuations. In a note published today, the pair write:

On balance KBW comes out somewhere in the middle, but with a view of risks skewed a bit to the downside.

That’s not to say Widner and Hagen don’t see some bright spots with discount valuations and attractive yields. Their top pick? Two Harbors Investment Corp. (TWO), which is “very well hedged against both rising and falling rates.” As they write:

At 0.92x our mark-to-market book value estimate it’s not the most discounted name in the space, but taking both the valuation and portfolio composition into account we believe it offers the group’s best risk adjusted return outlook today.

As is occasionally his wont, DoubleLine‘s Jeffrey Gundlach weighed in on the mortgage REIT market during his webcast this afternoon, namely Annaly Capital Management (NLY), which he says he does not own.

To be fair, the guy knows a thing or two about mortgage bonds, which he owns plenty of, and the mREIT topic came up in response to a direct question during the Q&A part of the presentation. The questioner said Gundlach had said he liked NLY back when it was trading in the $11 range, and asked his thoughts now that it’s at $10.20. Gundlach responded that he still thinks NLY is “fine if you’re a long-term holder” and that the company is “very well run,” adding that “insider buying of something that is rather opaque versus other types of companies is a good thing,” referring to recent management purchases of NLY shares.

However: “I don’t own Annaly,” Gundlach said, and “I don’t think there’s any hurry to buy because I think the dividend is going to be cut…. I think Annaly can earn about a dollar, so at $10 a share you get a yield of 10…. It’s not like you’re going to be cash-flow starved.”

He added that at least NLY “is trading at a discount to its book value, which is always a good thing.”

The rest of the mREIT sector is struggling as well Friday. American Capital Agency Corp. (AGNC) is down 2.1% to $23.27; CYS Investments (CYS) is down 1.5% to $7.97; Two Harbors Investment (TWO) is down 0.8% to $9.98 and AG Mortgage Investment Trust Inc. (MITT) is down 1.5% at $16.87.

Mortgage real-estate investment trusts are on an upward leg of their high-volatility yo-yo ride Tuesday, with some robust gains following Monday’s steep losses. Markets everywhere are gyrating on the day-to-day sentiment swings regarding the Federal Reserve’s plans to wind down its $85 billion monthly Treasury and mortgage bond-buying program, but perhaps no sector has been so acutely subject to that volatility as mREITs, which are following Treasury prices higher Tuesday after following them lower Monday.

Flagship mREIT American Capital Agency Corp. (AGNC) is wiping out Monday’s losses with a 5.29% gain so far Tuesday, but rallies in some other mREITs haven’t quite matched the magnitudes of their drops over the past trading day or two. CYS Investments (CYS), a big loser yesterday, was recently up a modest 2.0%. Annaly Capital Management (NLY) is up 3.56%. Hatteras Financial Corp (HTS) is up 1.35% and AG Mortgage Investment Trust Inc. (MITT) up 3.94%.

All this volatility is really just all about the Fed, but for some more context this blog has written repeatedly about the mortgage REIT rout that’s accompanied the sharp rise in interest rates that started in May. mREITs were also the focus of my Current Yield column in Barron’s magazine a few weeks ago, when second-quarter earnings reports seemingly promised to offer some better clarity on mREIT book values and suggested mREIT share prices might soon find a floor, but instead the volatility continues.

Following an extended rout for mortgage real-estate investment trusts, things just got worse for Hatteras Financial Corp (HTS) today, with HTS shares recently down 10.7% to $20.28. The company reported net income of $65.3 million, or $0.66 per diluted common share, versus $61.8 million, or $0.62, during the previous quarter, while net interest income fell to $63.4 million from $71.4 million the previous quarter reflecting decreasing portfolio yield. Hatteras’ book value per common share fell to $22.18 on June 20 from $28.18 on March 31, saying its agency securities declined in price without a similar rate of increase in the value of its interest rate hedges. Here’s Hatteras CEO Michael R. Hough in a statement:

A market sell-off resulted in U.S. Treasury and agency security interest rates increasing steadily throughout May and June with spreads over the Treasury curve widening to levels higher than we’ve seen since the Federal Reserve’s first quantitative easing program. Prices on hybrid adjustable-rate mortgage securities (ARMs) moved dramatically during the last two weeks of June and underperformed relative to fixed-rate mortgage securities. This was compounded by the less orderly markets over quarter end.

While we have always managed to a longer term horizon, periods of short term volatility must be managed independently. Our business model has proven resilient in the past and is designed to provide flexibility to better manage through periods of volatility. The liquidity position we had heading into the sell-off enabled us to be in control and protect the portfolio we have built. While we like how Hatteras is positioned for the now improved investing and prepayment environment, we will closely monitor the markets and adjust our portfolio accordingly.

Hatteras declared a dividend of $0.70 per share for the quarter, unchanged from the previous quarter, which had represented an 11.4% annual dividend yield based on yesterday’s closing price of $24.64 but is now up to 13.8% based on today’s sharp price drop.

Other mREITs are also seeing losses late Wednesday morning, with AG Mortgage Investment Trust (MITT) down 2.7%, American Capital Agency Corp. (AGNC) down 3.5%, Annaly Capital Management (NLY) down 2.8% and Two Harbors Investment (TWO) down 2.6%.

JP Morgan this week cuts the price targets on all the residential mortgage real-estate investment trusts it covers “due to the sell-off in interest rates, agency MBS, and Prime and Alt.A MBS.” This comes after several other financial firms cut their mREIT price targets recently to catch up with actual share prices following the mREIT sell-off of the past few months.

JPM cut AnnalyCapital Management (NLY) to $10.50 from from $13 with a neutral rating; Western Asset Mortgage Capital Corp. (WMC) from $22 to $15 with a neutral rating; Apollo Residential Mortgage Inc. (AMTG) from $22 to $16 with an overweight rating; and MFA Financial (MFA) to $8.00 from $9.00 with a neutral rating. Here’s JPM:

During the quarter, residential MREITs in our coverage universe sold off approximately 20%. NLY, MFA, WMC, and AMTG were all subject to higher interest rates and higher agency yields during the quarter. However, MFA and AMTG have significant allocation to Non-Agency MBS which either declined less severely than Agency MBS (Prime and Alt.A) or traded higher (Sub-prime). As such, we believe that MFA’s and AMTG’s MBS portfolios did not decline as much as those of pure-play agency MREITs. Additionally, both WMC and AMTG have payer swaptions in addition to pay-fixed swaps, which we would expect mitigated some of the losses on Agency MBS.

Our 2014 price targets for residential MREITs reflect a slight discount to NAV (0.95x) to account for heightened volatility and risk bias towards higher rates. We note that we do not explicitly model changes in MBS markto-markets outside of the customary “pull to par” (as all fixed income instruments move closer to maturity, prices move closer to face value, even if rates and spreads do not change or change as expected). We believe consensus forecasts for higher rates are already priced into current valuations.

JPM also looked at commercial mortgage REITs, which it says declined by 14% during the quarter, cutting its target on Ares Commercial Real Estate Corp (ACRE) to $15.50 from $17.50 with an overweight rating, while keeping its $16.50 price target and neutral rating for Apollo Commercial Real Estate Finance (ARI) and initiated a price target of $28.50 for Blackstone Mortgage Trust (BXMT) with an overweight rating. “With the exception of ACRE (which issued a dilutive equity offering), we do not feel the sell-off is warranted on the basis of fundamentals,” JPM writes.

Sterne Agee becomes the latest in a string of firms to cut price targets on mortgage real-estate investment trusts (said target price cuts often coming after actual prices have already fallen well below previous targets) and try to asses where the sector is going from here, following a months-long period of price declines and a sharp sell-off last Friday. Quoth Sterne strategists Henry J. Coffey, Jr. and Calvin Hotrum:

The spike in the 10 year on the 5th of July and concerns over the vitality of REPO lines have done considerable damage to Agency RMBS values and the book values of agency only M REITs. We have not liked agency only M REITs for some time and would continue to avoid this sub-corner of the M REIT market…. [O]ur fear is that book values will continue to fall, REPO dealers will start to reduce advance rates at the same time M REITs want to buy agency bonds, and the dividends at agency only M REITs will fall over the next few quarters to levels more in line with reported core EPS.

Sterne points to Two Harbors (TWO) and AG Mortgage Investment Trust Inc. (MITT), which operate with blended strategies and are suffering some of the down pressure on book values, “but nothing akin to what the agency only M REITs are suffering.” In the case of MITT, Sterne says it expects a dividend of $0.70 to $0.80 per quarter. Sterne says TWO has made a number of dynamic shifts in its agency portfolio this quarter and in its latest filings “has indicated its book value is positively skewed towards higher rates,” with Sterne expecting a TWO dividend between $0.25 to $0.30.

Sterne also points to three companies – Home Loan Servicing Solutions, (HLSS), PennyMac Mortgage Investment Trust (PMT), and MFA Financial (MFA) - that it sees having rising book values and good dividend coverage.

On balance though, Sterne lowers its price targets on several of the mortgage REITs it follows, cutting AGNC to $22 from $25.50, MFA to $9 from $9.50, MITT to $21 from $26.50, NLY tp $10.75 from $14.25 and PMT to $24.50 from $28.50.

Citi weighs in this week on the recent collapse in mortgage real-estate investment trust prices, as a sharp sell-off Friday followed months of broad-based weakness:

In general, we continue to like the credit sensitive stocks and believe they are oversold, while maintaining our cautious stance on agency MBS focused REITs (no Buy ratings) given rate uncertainty…. While we recognize yield stocks are less compelling when long-term rates rise (and credit spreads have widen), getting 400-500 bps over Treasuries even if the 10-year goes to 3% is historically attractive. A stronger US economy is positive for their fundamentals and ROE’s will increase when the Fed ultimately raises short-term rates.

Looking at some specific mortgage REITs, Citi says it’s cutting target price for American Capital Agency Corp. (AGNC) down to $20 from $30 (it’s trading at $21.19 early Tuesday) and its target for Annaly Capital Management Inc. (NLY) to $12 from $15 (it’s currently at $11.86). Citi also reitierates a buy rating on PennyMac Mortgage Investment Trust (PMT). Citi adds that it believes the market has been too harsh on the commercial mortgage REITs and would buy Starwood Property Trust Inc. (STWD) and Blackstone Mortgage Trust Inc. (BXMT) at current price levels.

Citi says agency REITs could face more downside, as large agency MBS REIT stocks are down 25-35% over the past few months and trading at 0.8x P/B, after book values have declined due to MBS basis widening and higher long-term rates. Citi says liquidity in the agency MBS market remains thin with wider bid/ask spreads. More from Ciit:

We remain cautious on the agency stocks given our concern about higher rates going forward, though traders suggest much of the tapering risk is priced into the bond markets. And even if agency MBS REITs stabilize post-tapering, fears around the Fed hiking short-term rates could be lurking around the corner keeping sentiment negative. The bull case is that the economy is not strong enough for the Fed to taper yet, plus new investment spreads are wider and the stocks are below book value. Going into Q2’13 earnings, we expect reported book values to be down 10-15% for the agency REITs and believe mgt teams have been selling assets and increasing hedging activity which negatively impacts future earnings. There are several hybrids that own some non-agency MBS, but we believe their larger agency exposure will trump the lighter negative impact from non-agency.

Also this week, as analysts continue to try to make sense of what’s been happening to mortgage REITs, Wunderlich Securitiesdowngraded the entire sector while FBR Capital Markets called last week’s sell-off “an overreaction” that leaves prices looking attractive now.

Amey Stone is Barron’s Income Investing blogger and Current Yield columnist. She was formerly a managing editor at CBS MoneyWatch, MSN Money and AOL DailyFinance. Her responsibilities included overseeing market coverage and personal finance topics. Prior to those roles, she was a senior writer at BusinessWeek where she authored the Street Wise column online and contributed to the magazine’s Inside Wall Street column. Topics covered included economics, corporate finance, Fed policy, municipal bonds, mutual funds and dividend investing. She co-authored King of Capital, a biography of Citigroup Chairman Sandy Weill. She is a graduate of Yale University and Columbia University’s Graduate School of Journalism.